Enterprise Risk Management

Consider Both Sides of the Balance Sheet

by Patrick Sartor and Christopher Dall

Having an adequate view of an organization’s risk profile is an ever-present concern for businesses of all types. For healthcare organizations, this concern has grown into a major focal point as providers are bombarded on all sides with uncertainty. Healthcare reform, the regulatory landscape, changing demographics and even liabilities stemming from employee retirement plans all must be taken into account.

Enterprise Risk Management Provides a Holistic Approach

The risks to healthcare organizations should be viewed from a top down perspective, in aggregate, to evaluate how shifts in the risk profile will affect the business as a whole. Many healthcare organizations are pursuing Enterprise Risk Management (ERM) as an effective method to strategically and comprehensively evaluate risk.

PNC Healthcare prefers this definition of ERM:

“Enterprise Risk Management (ERM) is a structured analytical process that focuses on identifying and eliminating the financial impact and volatility of a portfolio of risks rather than on risk avoidance alone. ERM utilizes a process or framework for assessing, evaluating, and measuring all of an organization’s risks.[1]

This framework, described by the American Society for Healthcare Risk Management, can help a healthcare organization manage its balance sheet, both assets and liabilities. The standard asset-only or liability-only “siloed” approach fails to quantify potential correlations across the risk spectrum that will in turn impact the entire organization and its goals.

For healthcare organizations, proper evaluation of these risks can:

Help to maintain a favorable credit rating

Stabilize days cash on hand (DCOH)

Comply with debt covenants of their respective credit providers.

These are all pivotal metrics that can contribute to achieving consistent operations.

Credit rating stability allows an organization to borrow at competitive rate and reduce the costs associated with liquidity risks. Stable DCOH can help an organization to reduce the costs associated with borrowing and can contribute to credit rating stability. Compliance with debt covenants can help an organization avoid penalties and improve access to credit facilities for future use.

Proper attention to these three factors can help an organization prepare in the short term to achieve growth over the long term.

The Components of Enterprise Risk

We define five components of enterprise risk:

Unrestricted liquidity

Capital structure

Operations

Capital budgeting risks

Defined benefit plans

Taken in aggregate, these five components can significantly influence the credit rating and overall financial health of a healthcare organization. Proper management of these risks can lead to financial health while, conversely, mismanagement of these risks can lead to an unnecessary strain on operations.

When it comes to managing liability portfolios in the healthcare industry, standard practice consists of evaluating finance alternatives based upon a comparison of cost of capital followed by an assessment of the risk of each product alternative. This standard focuses on the liability side of the balance sheet, without necessarily considering the effect that assets have on the growth (or contraction) of said liabilities.

A Fresh Approach to Defining Enterprise Risk

The components of enterprise risk can be defined as a portfolio of liabilities. For this purpose, risk is bucketed into two categories: interest rate risk and liquidity risk. Interest rate risk covers the gamut of the general level of interest rates, basis risk[2] and tax risk. Liquidity risk measures the put risk associated with debt products and mark-to-market risk associated with interest rate swaps, especially with regard to the potential to reduce DCOH.

Once these risks have been defined and measured, the next step in the assessment is to stress test the liabilities and their potential negative impact (in adverse scenarios) on a healthcare system’s balance sheet and income statement. The components of the operations that can be evaluated with respect to these risks include:

Financial assets on and off (pensions) balance sheet

System operating cash flow

Major capital investments or acquisitions

From an investment perspective, the goal is to measure and determine the impact of changes to asset allocation and liability portfolio composition on organizational risk. A model should take a holistic view of the balance sheet and income statement such that you can manage risk (measured as probability of maintaining credit ratings or other user-defined metrics) by adjusting the levers of asset allocation, liability portfolio, and major capital projects.

Mitigating the Impact and Volatility of Enterprise Risk

Each healthcare organization has a different risk profile and unique circumstances. Here are two hypothetical examples of how healthcare organizations can take steps to mitigate the impact and volatility of their enterprise risks.

Case Study 1: Large healthcare system copes with a deteriorating operating environment

Imagine that a large healthcare system is faced with a deteriorating operating environment. Because of this, the healthcare system may decide to migrate some of its “risk” balance sheet investments to a more conservative, short-duration fixed income portfolio to ensure that the system has adequate liquidity to manage its cash flow and operational needs.

This strategy can help improve the healthcare system’s DCOH metric and mitigate the effect that a deteriorating operating environment could have on its credit rating stability.

A healthcare system like this might also want to evaluate a liability-driven investment strategy for its defined benefit pension plan, which could help mitigate the variability of the liability.

Consider a large regional system that wants to increase the impact that its longer-term investment portfolio has on its ability to fund strategic operations. The system maintains adequate liquidity through a large position in U.S. Treasury and Agency securities. As a result, it could fund a private investments portfolio to ensure that the operating assets pool was generating additional “utility,” in the form of incremental return, to support these strategic initiatives. In this case, the chief concern of the system might be related to shortfall risk, in that it would not want the returns on its assets to fall short of being able to fund these expenditures.

Conclusion

Incorporating both sides of the balance sheet can be essential to properly managing a healthcare organization’s enterprise risk in a holistic manner. Furthermore, doing so can help to maintain a level credit rating, stabilize DCOH, and comply with debt covenants. By performing an ERM analysis, a healthcare system can calibrate its investment portfolio to help ensure that it is optimized relative to its liabilities. Over the near term, this can help to provide continuity of operations; over the long term, we believe that this can help to fuel organizational growth.

Basis risk in finance is the risk associated with imperfect hedging. It arises because of the difference between the price of the asset to be hedged and the price of the asset serving as the hedge, or because of a mismatch between the expiration date of the hedge asset and the actual selling date of the asset.” Source: https://en.wikipedia.org/wiki/Basis_risk

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